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March 12, 2014

Insurance in Small Business Sucession Planning

As part of ThinkAdvisor’s Special Report, 21 Days of Tax Planning Advice for 2014, throughout the month of March, we are partnering with our Summit Professional Networks sister service,Tax Facts Online, to take a deeper dive into certain tax planning issues in a convenient Q&A format.

What is a buy-sell agreement?

Buy-sell agreements are often used in business succession planning where the business is owned by a relatively small group of owners who would otherwise have a limited market in which to sell their business interests. A buy-sell agreement often provides the remaining shareholders or co-owners with the option of purchasing the business interests of a deceased or withdrawing co-owner before the business interest is sold to a third party. Business entities such as closely held corporations, LLCs, and partnerships frequently rely upon buy-sell agreements when creating future business succession plans. A buy-sell agreement is essentially a contract to buy and sell a departing business owner’s interests in a business at some point in the future, usually upon the occurrence of one or more specified events.

A buy-sell agreement is typically structured as either a cross-purchase agreement or a redemption agreement. A cross-purchase agreement is an agreement among co-owners to purchase each other’s business interests upon the death or other withdrawal of one or more owners from the business. These agreements typically specify a predetermined purchase price and, in some cases, are funded by life insurance purchased to insure the lives of the various business owners.

Why are buy-sell agreements often used in business succession planning?

Use of a buy-sell agreement in the business succession planning context can mean the difference between the orderly withdrawal of a partner, whether by death or otherwise, and possible loss of control over a business by the remaining co-owners. In general, business succession planning is intended to ensure that the following goals are met:

(1) Preserving a deceased co-owner’s wealth and providing liquidity for his or her estate;

(2) Providing the remaining owners with the security of knowing they will maintain control of the business without unwanted third-party intervention;

(3) Ensuring business continuity, if so desired by the remaining business owners;

(4) Fixing the value of the business interest for estate tax purposes to avoid potential IRS intervention.

Interests in closely held corporations, LLCs, partnerships and sole proprietorships can have very limited markets for sale. This is particularly problematic when a deceased co-owner either has no heirs to inherit the deceased owner’s interest or has heirs who are poorly equipped or unwilling to take over the business. If the deceased business owner passes the interests to children who are not interested in continuing the business, they may be forced to sell their inherited interests at a discounted price to a third party. Executing a buy-sell agreement ensures that the business owner controls the disposition of business interests by allowing that owner to choose the buyer in advance. This type of succession planning also protects the value of the business as a whole and ensures that this value will pass to the owner’s estate without the need for protracted post-death negotiation.

Use of a buy-sell agreement can also ensure that the remaining business owners can continue the business without interference from a deceased owner’s heirs or the need for a third party investor following that owner’s death or early withdrawal from the business. The existence of the agreement will prevent a small business owner from selling the owner’s interests to outside investors who may not share the business vision of the remaining co-owners.

How is a buy-sell agreement funded?

A buy-sell agreement can be funded by using the prospective buyer’s own funds, accumulated earnings, debt instruments or insurance (either life or disability).

While self-funding on the part of the buyer is possible, many selling business owners may prefer the certainty that is provided through other funding methods. Self-funding presents the possibility that the buyer may be unable to obtain the funds upon the selling owner’s death or withdrawal.

As a result, many buy-sell agreements are funded through insurance. The type of insurance that is required will depend upon the triggering events specified in the buy-sell agreement itself. If a right to purchase under the agreement is triggered by the seller’s death, the buyer or business may fund the agreement by purchasing life insurance that insures the life of the selling business owner.

Death, however, is not the only type of event that may trigger a buy-sell agreement. If the triggering event is the selling owner’s disability or retirement from the business, funding may be provided more effectively through a disability insurance policy or a permanent life insurance policy that provides the potential for tax-free loans during the life of the insured. It is also common to treat an “involuntary transfer” as a triggering event. Essentially, this will become applicable if a creditor of an owner attempts to seize an interest in the business in pursuit of the collection of a debt. This can occur if an actual debt is owed to a third party or if one of the owners is subject to a divorce proceeding and the interest in the business is being transferred to a spouse who is not an owner. In the event that an involuntary transfer is a triggering event, than there will not be any insurance to fund the purchase.

If the parties have entered into a cross-purchase agreement, insurance funding is accomplished by the business owners purchasing insurance on the lives of each participating co-owner. The entity itself may also set aside accumulated earnings to fund a buy-sell agreement. In a closely held corporation, however, it might be difficult to set aside adequate funds when the operation of the business could benefit from the use of these funds. Further, in case of a C corporation, accumulated earnings above $250,000 can be subject to the accumulated earnings penalty tax. While accumulation of earnings and profits to meet the reasonable needs of the corporation is permissible, the parties must carefully evaluate the strategy to avoid the penalty tax, which may prove time consuming.

If insurance funding or accumulation of earnings has not been accomplished in advance, and the buying owners have insufficient cash on hand to fund the buy-sell agreement upon occurrence of a triggering event, a debt instrument can be used. The buying owners may be able to negotiate a series of payments to the selling owner or the estate. In choosing this option, the owners must consider whether the sale will be taxed under the installment sale rulesand the possible taxation (or deductibility) of the interest payments.

What are the consequences of using insurance to fund a buy-sell agreement?

Many business owners who structure a buy-sell agreement prefer to use insurance to fund the agreement.The insurance provides certainty that the purchase price will be funded, as it can be structured to pay out upon the occurrence of the triggering event(s), usually the death, retirement or permanent disability of the seller. A buy-sell agreement funded through insurance can raise several tax and nontax issues, however.

Various types of insurance can be used to fund a buy-sell agreement, including the following:

(1) Term life insurance. Term life insurance, which provides life insurance coverage for a set amount of time, is a possible funding mechanism, but because the insured may outlive the pre-set term of the policy, it may not present the best option for younger business owners.If the insured outlives the term, the policy may expire and the investment may be lost.

(2) Cash value life insurance.Various types of permanent life insurance that allow for a build-up of cash value within the policy may be used to fund a buy-sell agreement, and may be especially useful where the triggering event is not the departing business owner’s death.This type of insurance provides for a build up of cash value over time and permits the policy owner to withdraw a portion of the cash value tax-free.As a result, if the buy-sell agreement is triggered by an event such as the departing owner’s retirement or disagreement over S corporation dividend distributions, for example, the remaining owners can still access the cash value to fund the purchase.

(3) Disability insurance.Disability insurance can be used to fund a buy-sell agreement where the triggering event is the disability of the departing business owner.

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The above article was drawn from 2015 Tax Facts on Individuals & Small Business, and originally published by The National Underwriter Company, a Summit Professional Networks business as well as a sister division of ThinkAdvisor.
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